How to “Fix” an Employee Bonus Liability

An
employer that pays bonus payments in the
year after services are performed but
takes a deduction for the bonus payments
in the year the services are performed
may be using an improper method of
accounting.

Under Sec. 461, a liability is
generally incurred and recognized by an
accrual-basis taxpayer when all events
have occurred that establish the fact of
the liability, its amount can be
determined with reasonable accuracy, and
economic performance has occurred with
respect to the liability. All events
establishing the fact of the liability
have occurred at the earlier of the date
(1) payment is due, or (2) the event
fixing the liability occurs.

A liability for a bonus payment made
in the year succeeding the year of
service may become fixed in the year of
service, and may be deductible in the
year of service, provided the payment is
made within 2½ months after the
beginning of the succeeding year and the
employer is legally obligated to pay the
amount at the end of the year of
service, even if the payee remains
uncertain.

Employers that deduct bonus payments
in an improper tax year and are not
disqualified by the scope limitations in
Rev. Proc. 2015-13 or Rev. Proc. 2015-14
may voluntarily correct the timing error
and gain audit protection through an
automatic accounting method change.

The end of
the calendar year is associated with many pleasant
things—the holiday season, spending time with
family and friends, time off from work, and, in
some cases, bonuses from an employer. If the bonus
is paid to the employee before year end and the
accrual-method employer's liability is incurred so
that the employer is able to take a deduction by
year end, both parties are probably pretty happy.

But what if
the employee is not paid until the following year?
Under certain circumstances, the employer may
nonetheless have a deductible liability at year
end. However, the IRS and courts have increasingly
ruled that any ability of the employer not to pay out
some or all of its planned bonuses will keep the
liability from fixing until that retained
discretion is eliminated. Consequently, employers
with discretionary bonus plans that restrict
employees' right to receive a bonus may not be
able to recognize the liability and take a
deduction for bonus payments until the year after
the related services are performed.

If an employer has been
mistakenly taking a deduction in the earlier
year (i.e., the year of services), the employer
may be using an improper accounting method and
(assuming it does not want to revise its bonus
plans to eliminate the retained discretion) may
have to request an accounting method change to
correct the treatment and protect itself from
exposure for prior-year treatment. Although
inherently a timing issue, this could create a
permanent impact for employers if income tax
rates decrease in future years or for employers
that are organized as flowthrough entities,
where the owners are subject to higher income
tax rates, and lead to exposure and the risk of
penalties and interest for employers that are
improperly recognizing the deduction in the year
before payment is made.

Although the
proper timing for recognizing a bonus liability
and taking the deduction for bonus payments is
not a new issue, tax practitioners continue to
find employers using impermissible methods of
taking the deduction in a year prior to when it
should be taken under accrual-method rules. Many
times, this issue is discovered when an employer
engages a new tax preparer or a new auditor. For
financial statement purposes, employers using
U.S. GAAP may be taking the liability into
account in the year the related services are
provided. While this may be acceptable for GAAP
purposes, for federal income tax purposes the
liability might not be deductible until the
following year. Thus, employers that currently
are following book treatment and are not
calculating a Schedule M-1 or M-3 adjustment on
their return for bonus liabilities should, in
particular, consider reviewing their bonus plans
to determine whether such treatment is
permissible.

This article discusses
issues related to bonus liabilities of employers
on the accrual method of accounting, when the
bonuses are paid after the tax year in which the
related services are performed by the eligible
employee(s) but within 2½ months after the year
end.1This article describes
when a liability generally is incurred and
becomes deductible under the accrual-method
rules and how these rules affect the timing of
when bonus liabilities in particular may be
deductible by accrual-method employers.2 This article also
discusses steps a taxpayer that is on an
impermissible method of accounting for bonus
liabilities may take to limit exposure for prior
improper treatment and to correct treatment for
current and future years.

Although this
article provides a high-level overview of the
rules regarding deducting bonus compensation
liabilities for accrual-method employers, it is
not intended to provide an all-encompassing
discussion of every issue such liabilities may
raise.3Practitioners should
make sure to examine the client's specific facts
and circumstances prior to determining the
appropriate treatment of bonus ­liabilities and
prior to taking any steps to change present
treatment.

When
Is a Liability Incurred for Federal Income Tax
Purposes?

Accrual-method employers
generally must wait until a liability is
incurred before it can be taken into account
(either through deduction or capitalization, as
applicable).4The general rules for
when a liability is incurred are provided in
Sec. 461 (and the related regulations) and Regs.
Sec. 1.446-1(c)(1)(ii). These rules for
determining when a liability is incurred for
federal income tax purposes are thus the
foundation of identifying a deductible liability
for a given tax year.

Under Sec. 461 and
attendant regulations, for federal income tax
purposes, a liability generally is taken into
account by an accrual-method taxpayer in the tax
year in which all the events have occurred that
establish the fact of the liability, the amount
of the liability can be determined with
reasonable accuracy, and economic performance
has occurred with respect to the liability.5Thus, such taxpayers
are subject to a three-prong test for incurring
a liability.

The economic performance
rules vary depending on the type of liability,
and for many other liabilities economic
performance is the last event to occur. Because the employer's
liability for bonuses arises out of another
person's providing services to the employer,
economic performance occurs as that person
provides the services.6Therefore, in the case
of bonus liabilities that arise out of services
provided by an employee, by the end of the tax
year in which the services giving rise to the
bonuses are performed, the taxpayer will
generally have met the economic performance
requirement with respect to the liability.7

Even though economic
performance may have occurred for a liability,
the liability must also be fixed for a taxpayer
to recognize it for federal income tax
purposes.In many bonus liability issues seen
today, fixing of the liability happens last and
is thus often the biggest obstacle employers
with discretionary bonus plans face in
determining when the liability for such bonuses
is incurred and thus deductible for tax
purposes. Generally, under Regs. Sec.
1.461-1(a)(2), all the events have occurred that
determine the fact of the liability at the
earlier of (1) the event fixing the liability
occurs, whether that is the required performance
or other event, or (2) payment therefore is
due.8In
General Dynamics Corp.,9 the Supreme Court
noted that

[i]t is
fundamental to the "all events" test
that, although expenses may be deductible
before they have become due and payable,
liability must first be firmly established.
This is consistent with our prior holdings
that a taxpayer may not deduct a liability
that is contingent . . . or contested.10

Issues Affecting the Fixing of
Bonus Liabilities

Many discretionary
bonus plans include language and provisions
that, in the IRS's (and many courts') view, will
keep the liability from fixing until any
uncertainty created by that discretion is
eliminated. Ultimately, in court opinions and
IRS guidance, the key factor in determining
whether an employer has a fixed liability for
bonus payments appears to be whether that
employer has a legal obligation to pay the
bonuses.

For instance, often, an employer's
bonus plan will require an employee to be
employed on the date of the payout to remain
eligible to receive the bonus. If the plan does
not also include a provision requiring any
forfeited bonuses to revert to a pool to be paid
out to the remaining eligible employees, this
restriction will keep the liability from fixing
(and thus meeting the all-events test under Sec.
461) until the tax year in which payment is
actually made.In Bennett
Paper Corp.,11 the Tax Court held
that a taxpayer that, as part of its employee
bonus plan, required the employees to remain in
the taxpayer's employment until payment was made
to be eligible for the bonus, did not have a
fixed liability until payment was actually made.
The court noted that the requirement of
employment on the date of payment was a
contingency that rendered the taxpayer's
liability to pay the bonus uncertain and thus
"unfixed" until that contingency was
eliminated.

However, in The
Washington Post Co.,12 the Court of Claims
held that the taxpayer, a newspaper publisher,
did have a fixed bonus liability upon amounts
credited to a fund to reward dealers for their
contribution to the taxpayer's success. A dealer
could forfeit its right to payment from the fund
by terminating its contractual relationship with
the taxpayer. However, any forfeited amounts
would be reallocated to a pool to be paid out to
the remaining eligible dealers. Thus, amounts
credited to the fund were in all cases to be
paid by the taxpayer, even though the identity
of the payees remained uncertain. Because of
this reallocation provision, the court held that
while the amount may not have been fixed as to a
particular dealer, once it was credited to the
fund as a whole, the taxpayer had a fixed
liability to pay that amount.13

The IRS
initially took the position that it would not
follow the holding in The
Washington Post Co., stating that the
all-events test could be met only when the
"fact of the liability to a specified
individual participant has been clearly
established."14However, in 2011,
the IRS reversed its position on this issue and
ruled that a liability may meet the
fixed-and-determinable prong of the all-events
test prior to payment even where the identity of
the specific payees remains unknown until
payment is actually made.15

Additionally,
if a discretionary bonus plan requires the
employer's board of directors (or a similar
authority) to approve a payment before it is
made, such approval must occur before the
liability becomes fixed for federal income tax
purposes. This will affect the employer's
deduction, for example, where the bonus plan
creates a bonus pool based on a year-end metric
but specifically provides that the employer is
not obligated to pay out any amount unless and
until the board's compensation committee reviews
and approves the payment. Because those reviews
generally occur only after the close of the
year, when financial results are available, the
employer's retained discretion to alter the
extent to which the bonus pool will be
distributed may prevent the fixing of the
liability until that next year.

Further,
if the board resolution does not create a
legally enforceable right to the bonuses, the
liability still may not be fixed until the
employer does become legally obligated to make
the payment (which might not be until the actual
payment date). For instance, in Bauer
Bros. Co.,16 the Sixth Circuit
held that a taxpayer's liability to pay bonuses
to its employees did not fix when, prior to the
end of the year, the taxpayer's board of
directors informally voted to pay out bonuses to
its employees but did not make any accounting
entries on its books or provide any written
memoranda relating to the bonuses. Ultimately,
this informal vote by itself was not enough to
fix the taxpayer's liability since it did not
result in a "legal obligation which could
be enforced, either on the basis of express or
implied contract."17

Alternatively,
in Willoughby
Camera Stores18 the Second Circuit
held that a taxpayer did have a fixed liability
to pay bonuses when in December each year its
board of directors passed a resolution approving
the payment of bonuses during the next year,
issued a written memorandum to this effect to
its treasurer, who credited a reserve account to
pay them, and notified its employees. In the
court's view, these actions were enough to
provide a legal obligation (in the form of an
implied contract between the taxpayer and its
employees) to provide the bonuses.

In
2013, the IRS Office of Chief Counsel (OCC)
advised in a legal advice memorandum19 that an employer's
bonus plans retaining with the employer the
legal right to modify or rescind payment of
bonuses at any time prior to payment caused the
liability to not fix until payment. The taxpayer
provided several bonus plans under which
employees could receive cash bonuses that were
calculated based on achieving various metrics at
the company and individual levels. After the end
of each year, the taxpayer's board of directors
would review and approve bonuses. Although the
amount of bonuses was based on metrics
determinable as of the end of the year in which
the related services were provided, the board
had complete discretion to modify the amounts of
individuals' bonuses and could even decide not
to pay any bonuses. Because the taxpayer had a
unilateral right to modify the plan or eliminate
the bonuses, the IRS determined that the
taxpayer had no liability under the bonus plan
until the bonuses were paid. Although legal
advice memoranda are not to be used as
precedent, this guidance does provide insight
into how the IRS may analyze a particular
taxpayer's bonus plans to determine when the
liability fixes under the all-events test.20

It would
appear, based on court holdings and the IRS's
stated position in revenue rulings and other
guidance, that the government is likely to
assert that an employer's retention of
discretion to alter whether and how much it will
pay out in bonuses after the end of the service
year will keep the liability from fixing until
the contingency (whether it is board approval,
payment, etc.) is eliminated. If it is
determined that an employer is improperly
accounting for its bonus liabilities, the next
issue to consider is how an employer may correct
its treatment and protect itself in the
process.

How to Correct
Improper Treatment of Bonus Liabilities

If it is determined that an employer is
taking a deduction for bonus liabilities in an
improper tax year, this can generally be
corrected through an accounting method change
(i.e., filing a Form 3115, Application
for Change in Accounting Method). If
the employer is not disqualified by scope
limitations under Section 5.01(1) of Rev. Proc.
2015-13, the method change may be made
automatically. The scope limitations, which
affect whether or when the change can be made
automatically, address whether an employer is in
its final year of its business and whether it
has made a prior method change for bonus
liabilities.

If the scope limitations do
not apply to the employer, Section 19.01(2) of
Rev. Proc. 2015-14 permits a change to either of
the following methods: (1) if all the events
that fix a liability to pay a bonus occur in the
tax year subsequent to the tax year in which the
related services are provided, to treat the
bonus liability as incurred in such subsequent
tax year, or (2) if all the events that fix the
liability to pay a bonus have occurred by the
end of the tax year in which the related
services are provided and the bonus is received
by the employee no later than 2½ calendar months
after the end of the tax year in which the
related services are provided, to treat the
bonus liability as incurred in that tax year.

By voluntarily
correcting an improper accounting method under
Rev. Proc. 2015-13, a taxpayer that is not under
IRS examination, and in certain circumstances a
taxpayer that is under IRS examination,
generally receives audit protection (meaning
that the IRS generally may not make an
adjustment or method change for bonus
liabilities in a tax year prior to the year of
change) and will generally be able to spread the
income pickup required by Sec. 481(a) ratably
over four tax years, beginning in the tax year
of change. Automatic method changes generally
may be filed by the time the taxpayer timely
files (including extensions) its tax return for
the year of change. Therefore, calendar-year
employers that fully extend their returns may
have until Sept. 15 of the following year to
submit the required Form 3115.

If an
employer does not voluntarily correct an
improper accounting method for bonuses, the IRS
may make an adjustment or method change for the
bonus liabilities for any open tax years and may
require the employer to recognize the income
pickup required by Sec. 481(a) entirely in the
year the method change is made. Additionally,
employers that are subject to method changes as
part of an exam are not protected from interest
and penalty charges on the improper
treatment.

Potential
Implications

It would appear, based on
various court holdings and the IRS's discussion
in revenue rulings and other guidance, that the
IRS is likely to take the position that an
employer's retention of discretion until after
the close of the service year to alter whether
it will pay bonuses to its employees and the
bonuses' total amount will keep the liability
from fixing until that contingency (board
approval, payment, etc.) is eliminated. Whether
the terms of the employer's current bonus plan
run afoul of the IRS's interpretation of the law
is highly factual and requires considering all
of the relevant facts and circumstances.

If, after carefully reviewing its bonus
plans, however, an employer determines that it
has not been accounting for its bonus payments
properly, the employer will need to carefully
consider its options for correcting any
identified issues. These options may include
changing the terms of the bonus plan, retaining
the plan as is but changing the accounting
method for it for current and future years, or
some combination of the two. Bonus plans
commonly contain provisions granting the
employer a certain amount of discretion in
determining for nontax reasons whether and how
much to pay out in bonuses. As such, any
employer that currently deducts bonus
liabilities in the year the related services are
performed may benefit from reviewing its bonus
plans with its tax advisers to determine whether
the current tax treatment is appropriate and to
consider the various steps that may be need to
be taken in light of that review.

This
article represents the views of the authors
only, and does not necessarily represent the
views or professional advice of KPMG LLP or
McGladrey LLP. The information contained
herein is of a general nature and based on
authorities that are subject to change.
Applicability of the information to specific
situations should be determined through
consultation with your tax adviser.

Footnotes

1A
discussion of bonuses subject to the deferred
compensation rules (when payments are made more
than 2½ months after year end) is beyond the
scope of this article. Additionally, for
purposes of this article, the services provided
by the employees are assumed to be the normal
services provided in the course of their
employment during the tax year and are not
services tied to specific contracts or projects
that must be completed before an employee is
entitled to a bonus.

2For
purposes of this article, it is assumed that
taxpayers are using a calendar-year tax year.
However, the rules and analysis also apply to
taxpayers using fiscal tax years.

3For
instance, specific circumstances may require
that some portion of the bonuses be capitalized
rather than deducted (e.g., using the uniform
capitalization rules under Sec. 263A). These
issues are beyond the scope of this article.

7As
discussed above, this article assumes that bonus
compensation payments are made within 2½ months
after the end of the employer's tax year in
which the related services were performed. A
payment made more than 2½ months after year end
is considered deferred compensation that is
generally subject to different rules regarding
the timing of taking such liabilities into
account for federal income tax purposes.

20Sec.
162(m) bonus plans present different
considerations, a discussion of which is beyond
the scope of this article.

Contributors

Kate
Abdoo is a tax manager in the
Washington National Tax office of
McGladrey LLP focusing on accounting
methods and periods and is a member of the
AICPA Tax Methods & Periods Technical
Resource Panel. Karen
Messner is a tax senior manager in
the Washington National Tax office of
KPMG. For more information about this
column, contact Ms. Abdoo at kate.abdoo@mcgladrey.com.

The winners of The Tax Adviser’s 2016 Best Article Award are Edward Schnee, CPA, Ph.D., and W. Eugene Seago, J.D., Ph.D., for their article, “Taxation of Worthless and Abandoned Partnership Interests.”

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